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This time is different. No, really!

The phrase “this time is different” doesn’t usually spark very positive reactions. But I don’t care because there’s one thing about the market these days that makes me think that something is strange when compared to previous bond market sell-offs.

If you follow me on twitter you will have noticed that lately I have been talking a lot about asset swaps (ASW). This is a pretty technical concept but I will try to be as straightforward as possible.

If you are still reading this then you probably know that in the fixed income market we have two broad groups of instruments – cash bonds and swaps. In theory, their yields (prices) should be moving more or less in a parallel fashion because they are interest rates instruments. In other words, you can bet on interest rates going lower by either buying bonds or receiving interest rate swaps (IRS). The difference between those two instruments is called the asset swap and it tends to move for the following main reasons:

Buying government bonds creates exposure against the issuer (sovereign) while IRS is a contract between two counterparties (e.g. banks).

Supply of bonds is limited while IRS can be created out of thin air.

Government bonds are a stream of cash flows (coupons) while IRS is an exchange of fixed against floating rate (e.g. LIBOR).

I have learnt to pay a close attention to moves in ASWs, just like I very closely monitor moves in cross currency basis because they can reveal pretty significant market developments. An ASW can tighten, i.e. bond outperforms the swap (e.g. bond yields drops by 10bp and IRS for the same maturity by 7bp) or widen. In core markets, tightening of ASW has been historically connected with higher aversion to risk. When problems arise, investors would very much rather own, say, US Treasuries than have a contract with a bank to exchange some cash flows. Chart below shows the 10y ASW (the higher the number, the more expensive the bond vs swap) in the US against the EMBIG spread. As you can see, the correlation is pretty significant.

Now, what happens in developed markets does not usually work the same way in emerging markets. Indeed, periods of risk aversion were generally associated with significant widening of ASW in emerging markets. The rationale is simple – let’s dump emerging bonds because the credit risk is going up. Having an interest exposure via a swap with JP Morgan becomes more valuable than buying government bonds of governments of Mexico, Hungary or Malaysia. Simple heuristic.

And this brings me to the “this time is different” proposition. As you may have noticed we are experiencing the end of days for government bond markets. Well, we’re not really but people like Bill Gross want to make you think like that. EPFR data is showing significant outflows from bond funds investing in emerging government bond markets. The last time we saw such big outflows was in September 2011. However, unlike in September 2011 when ASW totally exploded, in the recent weeks EM ASWs have actually tightened and considerably so. Just to give you an example – ASW in the 10y segment of the South African government bonds are at the tightest level they’ve ever been. South Africa – the country whose economy is in a downfall, whose currency has sold off dramatically and where the social tensions are at levels unseen in years. To be sure, the bonds have sold off too but nowhere near as much as IRS.

I can find a few explanations for that but the most important conclusion is that real money investors (so asset managers rather than hedge funds) have not been selling government bond markets to a large extent. They have sold some and shifted others to more defensive places, they probably hedged their currency exposures but they have not sold their bonds. Why? Perhaps because they don’t believe Bill Gross, thinking the scare will pass (this argument seems to be supported by Pawel Morski in one of his latest posts). Or perhaps because they know the market is not able to absorb the potential flow anyway.

At the same time, the hedge funds seem to be willing to exploit the recent change in the global mood and are pushing IRS higher. This then stops out model accounts (CTAs, aka the scum of the earth), which had been running humongous receiver positions in bellies of various curves assuming the Fed would stay put forever (or at least 3-5 years). Meanwhile, it seems like the tide has turned a bit and the convexity of the US curve is shifting. That’s why I was pointing out earlier today this tweet from Business Insider’s Matt Boesler:

All in all, I don’t want to make this post too technical but this is the first EM bond “crisis” since I have been in the industry when local bonds in emerging markets have so far been outperforming IRS and ASW have been tightening. And while I think I understand the reasons behind that this is not a sustainable situation, in my opinion. In fact, I strongly believe that something has to give – either the real money guys are in a denial or the hedge funds have jumped on the tapering bandwagon too early. Either way, the EM curves are pricing something that is almost impossible to come true, in my view.

13 thoughts on “This time is different. No, really!”

Our view is that your inability to exit point is correct. Here in Asia street-side liquidity provision is a fraction of what it once was (IG, HY and local mkts). This week, CDS volumes in sovereigns and index have been decent but relatively little has gone though in cash and best interpretation we can come up with is that this is the only market allowing overly long funds to de-risk in size. One of the Frank-Dodd chickens coming home to roost.

various reasons:
they destroy liquidity, exacerbate moves and generally trade based on stupid signals (ok, that last one is not really a criticism – they can trade on whatever they want – but it simply angers me)
also, there are a few systematic funds that i actually don’t mind but they are in minority

Nice post. Maybe you can shed some light on something I’ve been pondering: Why do you think 3M JIBAR is so sticky? Big sell off in the FRAs and then the fixing doesn’t budge an inch? You think local banks have a good reason to keep it down?

Perhaps but 3m jibar is primarily a function of sarb repo, isn’t it? There are no liquidity issues or bank problems so it really doesn’t need to move up unless the market really stars assuming imminent rate hikesa

Seems that way. I guess you have to be pretty brave to sell some 2x5s here with the expectation that they aren’t forced to hike and you earn the roll down (provided you can wear any mkt to mkt in the meantime). I’d be interested to hear your take on CEEMEA curves.

“However, unlike in September 2011 when ASW totally exploded, in the recent weeks EM ASWs have actually tightened and considerably so. Just to give you an example – ASW in the 10y segment of the South African government bonds are at the tightest level they’ve ever been.”

I’m not seeing this, swap rates are much higher than bond yields these days, steepening their spread greatly. Or am I mixing things up?

Isn’t this just another way of saying that during previous EM selloffs there was a significant risk of default risk in the EM debt? Here is seems like a pure currency move, so unlike in 2008, an ASW may not be more valuable than the underlying bond as the credit risk in the latter hasn’t moved.